Orlando's Outlook: We're sticking with our soft-patch thesis

Bottom Line Domestic economic growth has clearly downshifted during the March-through-May period, due to the accelerating sovereign-debt crisis in Europe (with specific concern about Greece and Spain), the residual impact from the October-to-March spike in energy prices, an emerging-markets slowdown in India, China and Brazil, and ongoing policy dysfunction in Washington, with particular focus on the looming fiscal cliff and the upcoming election. While the recent weakness in consumer spending, manufacturing and employment prompts us to trim our forecasts for Gross Domestic Product (GDP), we are standing pat with our expectation for a temporary economic soft-patch, which we believe the S&P 500 has already priced in over the past two months with its 11% correction.

The equity and fixed-income investment professionals who comprise Federated’s Macro Economic policy committee met on Wednesday, acknowledging the recent weakness in several key economic metrics and trimming our GDP forecasts. But Federated’s macro policy committee also reiterated its soft-patch forecast for 2012.

• The consensus first-quarter estimate for GDP was set at 2.5% when the Commerce Department flashed a huge miss with its initial reading at 2.2% in late April. Moreover, the first revision on May 31 took that disappointing reading down even further, to only 1.9%. So with the final GDP growth rate at 3.0% in the fourth quarter of 2011, our long-standing soft-patch forecast for this year has already been clinched.    
• The remaining question, of course, is one of timing—will the soft patch prove transitory, as we now expect, or will it morph into a double-dip recession?
• With weaker-than-expected trends in employment, consumer spending and manufacturing over the past two months—essentially locking in the first two-thirds of the second quarter with poor data—we are cutting our second-quarter GDP growth estimate from 2.5% to 2.2%, while the Blue Chip consensus has trimmed its estimate from 2.3% to 2.1%.
• Although the spike in energy prices has started to reverse, slower growth from Europe and the emerging markets, and fiscal policy drag from Washington could still collectively slow third-quarter economic growth.  So we are trimming our GDP estimate from 2.7% to 2.5%, while the Blue Chip consensus estimate drops from 2.4% to 2.2%.  
• We expect bold fiscal and monetary policy responses both here and abroad around midyear, which we believe will begin to bear some preliminary fruit by year end.  Nonetheless, we remain concerned about timing and lags, so we are trimming our estimate for fourth-quarter GDP growth from 3.0% to 2.7%, compared with a reduction by the Blue Chip consensus growth estimate from 2.6% to 2.4%.   
• Combining the weaker-than-expected first-quarter GDP, and our modest estimate reductions over the next three quarters, we are collectively lowering our full-year 2012 GDP forecast from 2.3% to 2.2%  (versus 1.7% growth in 2011), while the Blue Chip consensus estimate comes down from 2.3% to 2.1%. 
• We expect good election results on Nov. 6, and we believe that economic and political realities will force Washington to address and defuse the fiscal-cliff issues either in a lame-duck session or during the first half of 2013, resulting in much stronger economic growth next year compared with this year. But because we’ve reduced our 2012 estimates, which effectively lowers the base for 2013, our full-year 2013 GDP forecast ticks down from 2.9% to 2.8%, versus the Blue Chip consensus, which is cutting its estimate from 2.6% to 2.4%. 

The Macro Policy Committee also made the following investment observations: 

Crude oil and inflation ease After crude oil (West Texas Intermediate) soared by 44% from $77 per 42-gallon barrel last October to $111 in early March, crude has since experienced a sharp reversal, plunging by 27% over the past three months back to $81.  That has reduced the national average price for a gallon of unleaded gasoline from $3.95 to $3.53 and falling. The chief reasons for the drop are demand destruction in the face of a weakening global economy relative to supply gains, a stronger dollar versus the euro, and a reduction in Middle East geopolitical tensions regarding Iran’s nuclear plans.  Consequently, nominal inflation has begun to trend lower over the past two months, as well, and core year-over-year inflation is now running at relatively well behaved levels of 2.7% and 2.3%, respectively, for the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI) through May. The core Personal Consumption Expenditure (PCE) index—the Federal Reserve’s preferred measure of inflation—has ticked down to 1.9% year-over-year through April, which remains within the Fed’s 1.0% to 2.0% target range. While we remain vigilant over accommodative monetary policy and longer-term inflation risks that could spike benchmark Treasury yields, inflationary pressures have clearly eased in the near term. But we’re keeping our duration target at a very low 85%.    

Fed to extend “Op Twist” The Federal Reserve’s upcoming June 19-20 Federal Open Market Committee (FOMC) meeting will be important, with the Fed’s Operation Twist program scheduled to end later this month. We expect the Fed to extend Op Twist in some form and reiterate that it will remain highly accommodative with its current near-zero interest rate policy (ZIRP) into late 2014. But we still see no economic justification for a new QE3-type program at this time, as we expect that the Fed would like to keep some powder dry in case the U.S. economy plunges back into recession in response to some global economic shock. Still, if we’re right about a resumption of stronger domestic economic growth next year, we would not be surprised to see the Fed end ZIRP and begin to change its accommodative language and raise the benchmark fed funds rate by the end of 2013.

Employment falters The labor market has taken a decidedly ugly turn over the past three months. After posting a relatively healthy average monthly gain of 252,000 jobs during December, January and February, nonfarm payrolls in May rose by a putrid 69,000, which is trending lower from 77,000 jobs in April and 143,000 jobs in March.  Initial weekly jobless claims (an important leading economic and employment indicator), which had bottoming at a four-year low of 351,000 in mid February, are now sitting at 386,000 for the week ended June 9, with the smoother four-week moving average now at 382,000.   Clearly, employment is moving in the wrong direction. Private hiring has followed the disappointing nonfarm trends over the past quarter, while construction and government have both lost jobs in each of the past three months, manufacturing gains are sitting just above a five-month low, temp gains have slowed, and ADP gains are much weaker than expected. The only bright spot in May was the household survey, which gained 422,000 jobs, reversing job losses in March and April. The rates of unemployment and labor impairment rose to 8.2% and 14.8%, respectively, last month, while the labor force participation rate at 63.8% is just above a 30-year cycle low. 

Consumer rolling over After surprisingly robust January, February and March retail-sales results, April and May fell hard, likely due to the aforementioned weak employment trends over the past quarter. Retail sales in May were particularly disappointing, exacerbated by a sharp downward revision into negative territory for April. Now, we correctly forecast that April’s results would be soft due to the Easter calendar shift.  But we fully expected a healthy rebound in May—in part because ICSC chain store sales rose by 1.7% in May versus only a 0.6% rise in April—and that clearly didn’t happen, as the recent decline in energy prices and inflation have not yet begun to filter through to the consumer. June and July tend to be relatively unimportant summer clearance months for the industry, so consumers may not regroup before the important Back-to-School season kicks off in August. In addition, there has been a confusing divergence in consumer confidence over the past three months between the Conference Board and Michigan indices, with the Conference Board rolling over from its February peak while Michigan continued to rise. But that may have begun to change for the worst this morning, with Michigan’s preliminary June reading falling sharply to 74.1 from its robust May level of 79.3.  Moreover, consumers have continued to drive their personal savings rate down to 3.4% in April from 3.5% in March, 4.7% in December, and a 15-year cycle high of 7.2% in June 2009. All of this could have a negative impact on second- and third-quarter GDP trends, as consumer spending accounts for 70% of GDP.

Manufacturing softens The good news is that the national ISM manufacturing and services indices through May continue to signal moderate growth, with readings in the mid-50s. But several of the important regional Fed indices we monitor—Empire, Philly Fed, Chicago, Richmond and Dallas—have all suffered a sharp hit in their most recent readings. Factory orders and durable and capital goods orders were all negative during April, although business and wholesale inventories have begun to perk up after a soft first quarter. Industrial production posted its largest monthly gain in April since December 2010, while capacity utilization hit its highest point since August 2008, although both of those positive trends slipped a bit in May. Over the past three months, total vehicle sales have fallen by about 9% in May to 13.73 million annualized units, likely due to the spike in gasoline prices. But the overall sales trends are still up 17% from May 2011 and 51% higher from the cycle trough of 9.1 million units in February 2009. Finally, the trade deficit shrank by 5% in April, due to an energy-related drop in imports, while exports slipped for the first time in five months to a level just below March’s record high, which should boost second-quarter GDP.